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Case 1: XYZ pays a dividend. We reinvest all dividends back into XYZ

Case 2: XYZ does not pay a dividend

In Case 1, you end up with more shares of XYZ than Case 2, but the shares will be worth less than the shares of Case 2 by the amount of the dividend (ceteris paribus). Hence, the monetary value of your investment in XYZ should remain the same in either case.

However, there are additional costs associated with Case 1:

  • The dividends will be taxed

  • There are fees associated with DRIP (either that the company pays or that you pay)

  • XYZ could potentially make a better ROI for you as a shareholder by retaining dividends

As a result, wouldn't it be better (for you at least) if the company hadn't distributed a dividend altogether?

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  • It could also depend how many investors/shareholders there are. If not all of you want to re-invest, then your holding will increase. Companies sometimes shortcut this (as a tax-benefit) and this is known as a Scrip Dividend
    – Matthew Steeples
    May 21 '20 at 17:18
  • I don't understand - if the company does not pay you dividends, then the dividend is not your money, it's the company's. It doesn't matter if the company uses that money on something to make themselves grow, the value of your stock only goes up if that transforms into growth for the stock - which doesn't always happen even when a company is doing well.
    – Zibbobz
    May 21 '20 at 18:27
  • I understand that, that's why I used the word "potentially"
    – PacoK
    May 21 '20 at 18:36
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    The better question is whether you'd prefer the company not pay dividends and instead use the money to buy back its own shares.
    – David Schwartz
    May 23 '20 at 2:29
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Not necessarily. Your reinvestment has no direct effect on the company. But if there were no dividend, all that cash (that would otherwise go to dividends for all shareholders) would be retained by the company and would have to be invested somehow.

XYZ could potentially make a better ROI for you as a shareholder by retaining dividends

Those are the companies least likely to be paying dividends. Shareholders want a company to pay a dividend because it has more cash than it can usefully invest into its business. The closest thing to a substitute for a reinvested dividend would be if the company instead used the money to buy back shares.

The dividends will be taxed

For long-term shareholders, dividends are usually taxed at the same rate as the additional capital gains that would otherwise occur if the company retained the dividend. Thus, with a reinvested dividend, your capital gains are reduced (higher basis from reinvestment) and it's a near wash.

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  • 3
    The first part is the key point imo, a company has to be able to make efficient use of its profits, and for some the best use is paying out dividends.
    – Hart CO
    May 21 '20 at 4:50
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    "For long-term shareholders, dividends are usually taxed at the same rate as the additional capital gains that would otherwise occur if the company retained the dividend." - this statement is misleading. You would only pay capital gains tax if you actually sold your shares. If you don't sell, you get to defer capital gains tax until you do sell, which is significantly more efficient than having to pay tax on a dividend immediately.
    – user2357112 supports Monica
    May 21 '20 at 11:04
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    There are so many ways to avoid the capital-gains tax (particularly charitable contributions and inheritance) that the deferral is not just a hand-waving triviality.
    – chrylis -cautiouslyoptimistic-
    May 22 '20 at 1:09
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    @nanoman I don't think you can call it "a near wash". Suppose there are two stocks, APPR and DIVI. APPR appreciates by 4% per year and does not pay dividends. DIVI remains at the same price and pays 4% per year in dividends. If the tax rate on both realized gains and dividends is 25%, then an investment in APPR will grow at 4% per year (with a 25% tax on gains when I sell), whereas an investment in DIVI will only grow at 3% per year. If you invest $1,000 in each and hold for 40 years, APPR will be worth $3,851 after taxes, but DIVI will only be worth $3,262.
    – Tanner Swett
    May 22 '20 at 4:23
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    capital gains tax rates and dividend tax rates are both jurisdiction dependent. I don't think you can say in general that they are equivalent.
    – craq
    May 22 '20 at 5:43
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One factor that you didn't mention is that qualified dividends are taxed at a lower rate which is good but they're still taxed so overall, it's detrimental.

For a dividend paying stock,.share price must appreciate by the amount of the dividend plus another proportional amount for the tax bite less a proportional amount for the compounding of reinvested dividends.

The short answer is that if a dividend is received in a non sheltered account, it's tax inefficient.

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  • Are you accounting for the increased basis from reinvestment, which will reduce the subsequent capital gains tax? (Or alternatively, if the dividend isn't reinvested, the lower value of the stock will likewise reduce the capital gains tax.)
    – nanoman
    May 21 '20 at 5:01
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Consider that qualified dividends are taxed same as long term capital gains. A family grossing as much as $100K will see a 0% rate on their dividends. This raises their basis over time, and reduces their total capital gains at the time the stock is sold. For the typical investor, this makes reinvested dividends potentially a better deal.

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  • But without the dividend, you could just perform tax gain harvesting, selling shares and immediately repurchasing them to raise your basis that way. Tax gain harvesting lets you choose how much you want to raise your basis and when, unlike dividends, where you have no choice.
    – user2357112 supports Monica
    May 22 '20 at 2:35
  • Is this for the USA? (Source would be good.)
    – craq
    May 22 '20 at 5:46
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Case 2 misses out a vital point: Other people don't plan to reinvest the dividends, so to them a share that pays dividends is worth more than one that does not, which will no doubt up the price of shares that do pay out. This makes the dividend-paying share worth more to an investor who wishes to reinvest than a non-paying share, because the share's value will be higher.

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    I'm not sure this really makes sense assuming investors are rational. All else equal, the investors who don't plan to reinvest dividends could generate the same cash flow from an x% dividend by selling x% of their shares. This makes a company that distributes a dividend no more valuable to this type of investor than if the same company had not distributed a dividend. Of course the disadvantage is that you will lose some voting rights by doing this, and, as others have mentioned, it's in the company's best interest to distribute the dividend if they cannot make good use of it.
    – PacoK
    May 21 '20 at 19:07
  • @PacoK If it's in the company's best interest to distribute the dividend, it's in the shareholders' best interest. A "do-it-yourself" dividend via selling shares not only loses voting rights, but it doesn't enable using the company's cash pile more productively. You're still left holding shares in an "underleveraged" company with excess cash limiting its return on equity and thus limiting your investment's growth rate. Arguably a truer do-it-yourself dividend would be for you (the shareholder) to increase your portfolio leverage, effectively borrowing some money against your stock.
    – nanoman
    May 21 '20 at 23:32
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Expanding a bit on J. Mini's answer, which I think is the biggest point here: the answer is because some investors want dividends, not further investment by the company.

Profitable companies could be thought of as being in one of three phases: rapid expansion; steady growth; or established companies with little room for growth (or even contracting).

  • Companies in phase 1 are not paying dividends - they're putting every cent of profits back into the company to grow.

  • Companies in phase 2 could pay dividends, if they have extra money they don't have anything useful to put it in.

  • Companies in phase 3 are basically always paying dividends; any money they don't pay back in dividends is just going to sit in a bank account somewhere gathering dust.

As to why paying this as a dividend makes sense over keeping it: because it's how you pay back investors. You're right that you reduce the value of the company some, but it's basically irrelevant - other than having a rainy-day fund [which companies should have, but investors often aren't too keen on], the point of a company is to turn $1 input to $5 output, right? Cash in a bank account is turning $1 input to $1.01 output; that's not very interesting, and I'd much rather have that cash myself so I can further invest it.

Selling an equivalent part of the company would give me the same amount today, but again remember the point of any company: to turn $1 into $5. Work out the math here in an (very simplified) example.

  • Today I own 10% of company A, which has value $1M. I own $100k in value. It is in phase 3, so it will not reinvest those in growth.
  • Q1, company A reports $100k profits
  • Q2, company A reports $100k profits
  • Q3, company A reports $100k profits
  • Q4, company A reports $100k profits

In the dividend scenario, company A would pay out $100k dividends each quarter.

  • After Q1, company A is still worth $1M (as it gave its profits away, so it still has the value it had before); I have $10k extra, so I buy some extra Company A, now owning 11%.
  • After Q2, same scenario; I got $11k dividends, though, so now I can buy 1.1% more company A, taking me to 12.1%.
  • After Q3, I got $12k dividends (let's round off here), so I now can buy 1.2% more company A, taking me to 13.3%.
  • After Q4, I got $13k dividends, again rounding, so I can buy 1.3% more company A, taking me to 14.6%.

So now I have 14.6% of company A, or $146,000 in value.

In the second scenario, company A holds onto their cash...

  • Q1, Company A makes $100k, and is now worth $1.1M
  • Q2, Company A makes $100k, and is now worth $1.2M
  • Q3, Company A makes $100k, and is now worth $1.3M
  • Q4, Company A makes $100k, and is now worth $1.4M

So now you own 10% of that, and have $140k in value - $6k less than in the first scenario.

Finally, to show you why the activist investors want their dividend - what if I sold off shares instead of taking my dividend?

  • Q1, Company is now worth $1.1M. I sell off $10k worth of shares, or a bit over 9% of my holding. I now hold 9.1%.
  • Q2, Company is now worth $1.2M. I sell off $10k worth of shares, .83% of the company - now holding a bit under 8.3% of the company.
  • Q3, Company is now worth $1.3M. I sell off .77% of the company; I now hold about 7.5%.
  • Q4, Company is now worth $1.4M. I sell off .71% of the company, leaving me with 6.8%.

So now I hold 6.8% of a $1.4MM compaany, a holding worth $95k, plus that $40k I got from sales - quite a bit worse off than in the dividend scenario, even if you take away the reinvesting; keeping 10% of the company would leave me with $5k more. Obviously I could be reinvesting that $40k in other companies, but why would I want to do that since this company is making 10% profits on a quarterly basis? I want those dividends, either reinvested or not!

To recap, if you reinvest your dividends you end up with $146k at the end of the year, if you just keep your stock and the company doesn't pay dividends you end up with $140k, and if you sell stock each quarter to simulate your own dividend you end with $135k.

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  • In the "reinvest your dividends" scenario, the company grows 10% per quarter. In the "keep your stock/no dividends" scenario, the company grows 10% in Q1, 9.09% in Q2, 8.33% in Q3, and 7.14% in Q4. Clearly, you will make less money in the "keep your stock/no dividends" scenario because the company is growing less and less each quarter. While this can certainly happen in real life, it would be better to assume something like "the company grows x% every quarter with a dividend yield of y%". Then selling y% of your shares with no dividend would yield the same result.
    – PacoK
    May 22 '20 at 18:49
  • Furthermore, the "simulate your own dividend" scenario shouldn't even be compared to these other two (the proper comparison should be with dividend/no reinvestment).
    – PacoK
    May 22 '20 at 18:49
  • @PacoK The point though was that it does grow by less each quarter as a percent if it doesn't dividend, because it can only grow a fixed amount - i.e., the company has a set profit it can make from a set capital amount, and any extra capital doesn't grow.
    – Joe
    May 22 '20 at 18:51
  • Fair enough, the "Phase 3" assumption is the important thing I missed in your example. I guess I was approaching it more from a Phase 2 perspective. And if the example was Phase 1, then the opposite would be true.
    – PacoK
    May 22 '20 at 19:08

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